After 23 Years Of Falling Interest Rates, The U.S. Is At A Turning Point. When It Comes To Easy Money, The Party's Over. But We Should Be Fine.
By Andy Serwer Reporter Associates Anna Bernasek, Kate Bonamici, and Jeremy Kahn

(FORTUNE Magazine) – Besides little matters like Iraq and the 9/11 commission, the most common topic of discussion in boardrooms and at backyard barbecues--well, some barbecues, any-way--has to be interest rates. Rates have gone up a bit, of course, but that fact alone isn't necessarily cause for anguish. We've seen rates rise before, and a few basis points here or there is no big deal. The real question is, How high are they going? Will there be an endless series of rate hikes? Is our long era of low interest rates over? Could we possibly be entering a period of 1970s-type double-digit mortgage rates and stagflation, God help us?

Before we collectively hyperventilate over visions of gas lines and Jimmy Carter, we should establish two things: Interest rates are not going to increase that much in the near term, and it's not likely that we're reentering the sorry '70s.

Let's take a look at the data. Yes, the 30-year fixed-rate mortgage has moved up from 5.3% in mid-March to just over 6% at the end of April. The ten-year Treasury bond has bumped up similarly, and the reason is simple: The economy is improving. GDP growth has accelerated year over year for the past four quarters. In March 308,000 jobs were created--many more than expected--and job data for January and February were revised unexpectedly higher as well. Retail sales are growing at their fastest rate in four years. Durable-goods orders have strengthened for seven straight months, a string not seen since 2000.

Economic growth is all for the good, of course, but it can also engender that market-rattling side effect, inflation. And there has been a noticeable whiff of inflation of late: gas at $2 a gallon, milk at nearly $4 a gallon, and soybean prices moving up. Overall, consumer prices (excluding energy and food) rose twice as fast in March as in January and February.

Wall Street traders follow those numbers closely, and they have a term for what they are seeing. They call it "the turn"--the point at which one economic era ends and another begins. In this case the worry is we're talking about turn with a capital T. Just ask Paul McCulley, a managing director and portfolio manager at the giant bond house Pimco, whether the great long decline in interest rates we've enjoyed for more than two decades has finally run its course. "Yes, sir," he says. "It's over."

Okay, assume this is a turn. How bad is it, really? In the short term, life in a post-turn world will look a lot like a typical economic recovery.

And Ramzi Kawar can tell you how that feels. Kawar is co-president of a company called Pennsylvania Insert, which makes metal and plastic construction accessories for manholes and tunnels that hold wire and cable. "It seems like every day we get a letter or fax from a supplier saying, 'Sorry, but we have to raise prices,' " he says. "We make a tool called a pulling iron, which anchors cable while it is being pulled through a tunnel. It's made from steel strand. A year ago strand was going for 18 cents a foot. Our supplier called to say the price was going up to 19 cents, but he was going to absorb it. Then it went to 20, and he absorbed that too. After 20 cents a foot, though, he passed it on to us. We absorbed that until it hit 23 cents a foot. Now we are passing it on to our customers, and the price is up to almost 27 cents a foot."

That, my friends, is what central bankers are talking about when they assert, "Pricing power is gradually being restored." Says Keith Anderson, chief investment officer of fixed-income at BlackRock, the bond house: "If you read the earnings reports from the most recent quarter, you see all kinds of signs like that. You read about strong growth at Union Pacific and Weyerhaeuser and on and on." At Ford, demand for Mustangs is reportedly outstripping supply. Kimberly-Clark recently announced it was raising prices for TP (read bathroom tissue) by 6%. And Bill Zollars, chief executive of trucking giant Yellow Roadway, says, "Since the fourth quarter of last year we have seen the economy building every month. Business volume grew 4% in January, 7% in February, 8% in March, and 9% this month. We have several thousand more employees now compared with last year at this time."

Where is all that new business coming from? A lot of it is a pickup in domestic demand, but there are other forces at work too. "The price of some steel products has almost doubled since the beginning of the year," says Kawar. "Our supplier says it's because of strong demand for steel from China." Ah, yes, China: the single greatest inflationary force in the world today. Officially the Chinese economy grew 9% last year (some say the real number was more like 11%) and nearly 10% in the first quarter of this year. The giant nation faces shortages of raw materials like coal, oil, and steel.

Demand for those and other raw materials from suppliers in the U.S. has been rampant. In late April, Maine's Portland Press Herald reported that the "booming economy in China is pushing up the value of recyclables--cardboard, paper, metal, and plastics. Corrugated cardboard is bringing $95 a ton, up from $55 in January 2003 and as little as $35 a ton in early 2002. The price being paid for milk jug-type plastic has skyrocketed to $420 a ton from as little as $130 in early 2002. And the value of steel cans has jumped from $30 per ton just 11 months ago to $145 a ton in March. In 2001 the value was so low--just $4 or $5 a ton--that the entire price went for transportation."

But inflation is not likely to fly out of control, the abundant evidence of economic growth notwithstanding. In the case of commodity price increases, which have been impressive, there's reason to think the trend has peaked. One good sign: According to Merrill Lynch, this commodity cycle is already 29 months old, and an average boom lasts approximately 30 months. In fact, some materials, such as copper and gold, have already come down off their highs. As for oil, barring any really negative developments, crude prices are expected to move lower this summer as OPEC members increase supply.

Even the China factor isn't necessarily a problem. If the Chinese economy has become a bubble, as many fear it has, and bursts--or even if it just slows down to a sustainable pace, which is the more probable scenario--that contraction will have a dampening effect on the economy. Better still, the Chinese may yet succeed in their recent efforts to tap on the brakes. (For more, see "Why China Won't Hit a Wall" in First.)

What about other price pressures? Historically, the strongest inflation factor comes from higher wages, which on average make up about two-thirds of a company's total costs. There's just no sign of a pickup anytime soon on that front. Wages have barely been keeping up with inflation--and until there's a sustained rebound in the job market, wages aren't likely to budge. As far as Alan Greenspan is concerned, wage pressures aren't a problem until the unemployment rate drops to 4%, from the current 5.7%. For that to occur, March's rate of job growth (more than 300,000 new jobs) would have to be sustained for at least a year--hardly a sure thing. If it does happen, we'll still have plenty of warning. More important, even if jobs do come back strongly, further growth in productivity will probably help keep inflation at bay. (For a radically different view on the risk of hyperinflation, see following box.)

Watching every last twitch and quiver of all that data is Alan Greenspan. If the economy does smolder a little too hot, he will raise short-term rates to prevent it from overheating. When is the inevitable hike coming? Only the Fed knows for sure, but we can make some educated guesses.

First of all, don't expect the Fed to pounce right away. "I don't believe Greenspan will raise rates at the Fed meeting in May," says BlackRock's Anderson. "That would be aggressive. I think he'll change the Fed's statement to indicate that it is no longer patient." (Until now the Fed has said that it can be "patient" before it raises rates.) Greenspan may move this summer--there are Fed meetings in June and August. Will he refrain from raising rates because of the upcoming election? Not if he thinks raising rates is appropriate; a new report by Mickey Levy, chief economist at Bank of America, shows that the Fed is not at all shy about raising rates in an election year.

Second, the coming rate hike--or, more likely, hikes--won't be as much as the hysterics think. "The Fed wants to normalize short-term rates," says McCulley of Pimco. "What's normal? I think that means moving short-term rates to 2.5% by the end of 2005. That means kicking rates up 150 basis points, with positive real returns of half of 1%--meaning I think inflation will be around 2% then."

That doesn't mean we have nothing to worry about. A common view on the Street is that the economy will seamlessly and painlessly adjust to higher rates, which is certainly possible--maybe even probable. But it's always wise to be wary when the rosiest scenario is considered the most likely.

One obvious concern is the stock market. There's no question that sharply higher interest rates would be bad for stocks. When rates rise significantly, growth stocks are worth less because the market puts a lower value on the discounted stream of their future earnings. Think of it this way: Why would you want to own a stock with earnings growth of 10% a year, with all the risk that stocks entail, when you can put your money in short-term Treasuries yielding almost as much? If rates rise gradually, the collateral damage could be lessened by a faster-growing economy. A recent report by Morgan Stanley economist Richard Berner shows that a significant slice of an impending rate rise is already priced into stocks. Based on his firm's dividend discount model, stocks "won't look stretched until [ten-year Treasury] yields are well over 5%," he writes. (For more on how higher rates affect investing, see "How to Ride Rising Rates.")

The scariest points of interest-rate vulnerability are the invisible ones. As far as land mines go, here's the bottom line: We know some players are at risk, but we don't know who they are. As McCulley puts it, "The Fed has been running happy hour with its easy-money policy over the past few years. Someone is going to be filthy drunk. Let's just hope they don't try to drive home." But it's pretty much inevitable that someone will. In 1994 a whole flock of entities, among them the OC (all right, Orange County), got poisoned by bad bond investments and derivatives. And then there was the implosion of Long-Term Capital in 1998, the mother-in-law of all bad bond trades.

Don't think it won't happen this time, what with the ocean-loads of debt sloshing around in the system. On Wall Street, bond market leverage (as measured by primary dealer net borrowings) is more than $750 billion, up from $300 billion in 2000 according to a report by ING Investment Management. Hedge funds as well as treasury departments of ordinary corporations have bulked up on exotic bond derivatives and deals, such as "carry trades," where the investor borrows on the short end of the yield curve to buy bonds on the long end.

Consumers, too, are indebted to an almost unnerving degree. The Mortgage Bankers Association of America reports that in 1993, household debt amounted to 80% of after-tax income; today that figure stands at 110%. Americans have been leveraging up their real estate holdings, as evidenced by lower levels of equity ownership in homes. Based on figures from the Federal Reserve, in the early 1950s owners' equity as a percentage of household real estate was around 80%. Today it's 55%. What happens if rates climb suddenly and depress real estate prices? What happens to John Q. Einstein down the block, who refinanced and took all the equity out of his house? Trouble, that's what. ("Too many folks turned their homes into an ATM machine," grouses McCulley.) And, of course, rising rates could also crimp the housing market by making homes less affordable. Michael Martin, a loan consultant at Pacific Guarantee Mortgage in San Francisco, already reports that one Bay Area lender was averaging 1,000 new mortgage applications a day in mid-March. Now that number is down by half.

Another big worry is simply psychology. There really is a sense out there that 2004 is different, the most obvious reason being that rates have gotten so low that the only direction they can go is up. Today the Fed funds rate is hovering at 1%, the lowest it's been in 45 years.

Take yourself back to January 1981, around the time of the last turn. The Fed funds rate topped 20%. Around the same time, the ten-year Treasury bond, which is a bit over 4.3% today, peaked at 15.68%. The following 23 years were a period of nearly uninterrupted interest rate nirvana. Apart from hiccups like in 1987 and 1994, rates spiraled lower and lower, thanks in large part to the Fed's painful but highly effective war on inflation. Stocks rallied year after year, and so did bonds and the dollar. Ever cheaper money fueled an unprecedented housing boom and corporate growth as well. The great denouement of this era was the economic mania of the late 1990s and the ensuing crash. It was in the wake of the crash that the Fed slashed interest rates to their present historical lows. This because "the corporate sector was healing itself in the Betty Ford clinic for balance-sheet rehabilitation," says the always succinct McCulley.

Still, the party sure was fun, wasn't it? And just because interest rates are at rock bottom doesn't necessarily mean they have to go back up to the top. The point here is that homeowners, CEOs, owners of businesses--all of us--need to come to grips with the fact that moderately higher interest rates will probably be returning for the foreseeable future. The bond market is already factoring that into pricing TIPs (Treasury inflation-protected securities) vs. plain-vanilla Treasury bonds. Those who buy and sell Treasury bonds for a living may also be casting a wary eye at the massive budget deficit, which most agree is also inflationary. How high could rates go? Certainly to 7% on the ten-year bond, which has been the average over the past two decades. No reason to think we can't hit "average."

So don't expect a catastrophe. Your adjustable-rate mortgage isn't going to shoot up 270 basis points by Christmas. Look for gradually rising rates, some inflation, and the occasional blowup. But in all likelihood, this economy can handle "the turn."